Chapter 1: Economics—Foundations and Models (Study Notes)

Economics: Foundations and Models

Three Key Economic Ideas

Economics is built on three foundational ideas that help explain how individuals and societies make choices in a world of scarcity.

• People Are Rational: Individuals and firms use all available information to achieve their goals, weighing costs and benefits to make the best possible decisions. For example, a company like Apple sets prices to maximize profits, not randomly.

• People Respond to Economic Incentives: Changes in incentives alter behavior. For instance, requiring DNA samples from felons reduced repeat offenses, showing even criminals respond to incentives.

• Optimal Decisions Are Made at the Margin: Most choices involve doing a little more or less of something. Economists use marginal analysis—comparing marginal benefit (MB) and marginal cost (MC)—to analyze these decisions.

• Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Example: Deciding whether to study an extra hour or watch TV involves comparing the additional benefit of studying to the additional cost (lost leisure).

The Economic Problem That Every Society Must Solve

Scarcity forces societies to answer three fundamental questions:

• What goods and services will be produced? Due to limited resources, producing more of one good means producing less of another (trade-off). The opportunity cost is the highest-valued alternative given up.

• How will the goods and services be produced? Firms choose among different production methods, often influenced by costs and technology.

• Who will receive the goods and services produced? Distribution is often based on income, but government policies can alter this through taxes and welfare.

Types of Economic Systems

• Centrally Planned Economy: The government decides how resources are allocated.

• Market Economy: Households and firms interacting in markets determine resource allocation.

• Mixed Economy: Most decisions result from market interactions, but the government plays a significant role. The U.S. is best described as a mixed economy.

Efficiency and Equity in Market Economies

• Productive Efficiency: Goods and services are produced at the lowest possible cost, often due to competition.

• Allocative Efficiency: Production matches consumer preferences; every good is produced up to the point where MB = MC.

• Voluntary Exchange: Both buyers and sellers are made better off by transactions, continuing until no further improvement is possible.

• Equity: The fair distribution of economic benefits. There is often a trade-off between efficiency and equity (e.g., taxation may reduce efficiency but increase fairness).

Economic Models

Economists use models—simplified versions of reality—to analyze real-world issues and predict outcomes.

• Steps in building a model:

  1. Decide on assumptions.

  2. Formulate a testable hypothesis.

  3. Use data to test the hypothesis.

  4. Revise the model if necessary.

  5. Retain the revised model for future analysis.

• Assumptions: Models require simplifications, such as assuming consumers maximize well-being and firms maximize profit.

• Hypothesis: A statement about an economic variable, often about causality, that can be tested with data.

• Statistical Testing: Economists use data and statistical methods to evaluate hypotheses, though causality can be difficult to establish.

Positive vs. Normative Analysis

• Positive Analysis: Concerned with what is (facts and cause-effect relationships).

• Normative Analysis: Concerned with what ought to be (value judgments and policy recommendations).

Microeconomics vs. Macroeconomics

• Microeconomics: Studies individual households and firms, their choices, and market interactions.

• Macroeconomics: Studies the economy as a whole, including inflation, unemployment, and economic growth.

Examples of Microeconomic Issues	Examples of Macroeconomic Issues
How consumers react to price changes	Why economies experience recessions
How firms set prices	What determines inflation rates
Reducing opioid addiction efficiently	What determines exchange rates
Impact of AI on costs and employment	Can government reduce recession severity?

Economic Skills and Careers

Studying economics develops analytical, quantitative, and critical thinking skills valuable in many careers, such as:

• Forecasting demand (e.g., Ford Motor Company)

• Analyzing financial markets (e.g., Goldman Sachs)

• Policy analysis (e.g., Federal Trade Commission, World Bank)

• Teaching and research (e.g., universities)

Company/Organization	What an Economist Might Do
Ford Motor Company	Forecast demand for electric cars
Goldman Sachs	Forecast interest rates
McDonald's	Decide on opening new restaurants
Pfizer	Analyze costs/benefits of new treatments
Federal Reserve	Forecast employment trends

Example: Economics majors often earn higher median wages than other majors, but this may reflect both the skills learned and self-selection by high earners.

	Median Wage, Early Career (22-27)	Median Wage, Midcareer (35-45)
Economics majors	$60,000	$91,000
All majors	$45,000	$72,000

Important Economic Terms

• Scarcity: Unlimited wants exceed limited resources.

• Trade-off: Producing more of one good means less of another.

• Opportunity Cost: Highest-valued alternative given up.

• Technology: Processes used to produce goods/services.

• Capital: Manufactured goods used to produce other goods/services.

Appendix: Using Graphs and Formulas

Graphs and formulas are essential tools for analyzing economic relationships and presenting data visually.

• Bar Graphs and Pie Charts: Used to show market shares or proportions.

• Time-Series Graphs: Show how a variable changes over time.

• Plotting Price and Quantity: Demand curves show the relationship between price and quantity demanded.

• Slope of a Line: Calculated as the change in the y-axis variable divided by the change in the x-axis variable. LaTeX: $\text{Slope} = \frac{\Delta y}{\Delta x}$

• Nonlinear Relationships: The slope can vary at different points; tangent lines can approximate the slope at a point.

• Percentage Change Formula: LaTeX: $\text{Percentage change} = \frac{\text{Value in the second period} - \text{Value in the first period}}{\text{Value in the first period}} \times 100$

• Area Calculations:

  • Rectangle: $\text{Area} = \text{Base} \times \text{Height}$

  • Triangle: $\text{Area} = \frac{1}{2} \times \text{Base} \times \text{Height}$

Summary: Understanding and applying economic models, concepts of efficiency and equity, and graphical analysis are foundational skills for macroeconomics students. These tools help analyze real-world issues, inform policy debates, and prepare students for diverse careers.